HS-107 Readings Index

Economic Transitions of the Industrial Revolution                                     Prof. West

 
The Industrial Revolution may be understood to have gone through a number of distinct stages since its beginnings in Europe in the 17th and 18th centuries. It is useful to refer to the stages of economic growth described by Walt W. Rostow:

1. The agricultural stage is a pre-industrial stage characterized by the predominance of an agricultural economy with very limited craft manufacturing, commerce and trade, and a very slow rate of economic growth.

2. The pre-conditioning stage is characterized by a growing volume of craft manufacturing, commerce and trade, a proliferation of banking, insurance and financial services, and a significant accumulation of wealth.

3. The take-off stage is characterized by the development of power-driven machinery harnessed to the productivity of one industrial sector whose profits are extensive and are re-invested in the industry to achieve a high rate of self-sustained growth in the range of 10% to 25% per year.

4. The drive to maturity is characterized by the dissemination of a high, self-sustained growth rate to several sectors of industry, each stimulated by the wealth-generating productivity and resource demands of the others.

5. The age of mass consumption is characterized by the production of several large industrial sectors whose rates of growth have slowed down to a range of 3% to 5%, but whose industrial capacity is huge and able to produce an abundance of goods. Critical to a continued growth of the economy is the need for mass consumer demand to match the massive productive capacity of industry.

 

While all of these stages involve an increasing rate of change in the economy,  in the social and political arenas, the age of mass consumption requires fundamental structural changes in societal functioning. One can generalize by stating that in all stages previous to the age of mass consumption, the prevailing economic condition was one of scarcity, whereas with the age of mass consumption, the prevailing economic condition is surplus. This changes the rules by which society must function.

In an era of scarcity, a premium is placed upon increasing production, while consumption is not a significant factor affecting economic growth. There will always be some well-to-do consumers to purchase the goods that can be produced. The main problem is that productive capacity is insufficient to overcome the prevailing scarcity, and whatever can be done to increase production is going to be beneficial to overall economic growth. This does not mean, however, that shifts in occupation are not going to cause hardship for groups and individuals whose economic prosperity was based upon obsolete economic activities. In fact, large numbers of people will suffer the consequences of changing economic practices and new technology. However, many of those changes will be generally beneficial to economic growth in the long term. A large surplus of capital in the hands of the leading industrial minority is needed to invest in rapid economic growth, while masses of people living in poverty are not a serious obstacle to growth because consumption is not the central problem.

The government cannot involve itself extensively in the economy because it lacks the tax revenues and the resources to be a significant factor. In fact, political efforts to redress the imbalance of wealth may retard economic growth by depriving the industrial leadership of the profits needed to reinvest in further growth. The laissez faire ideology makes some sense under these conditions. On the other hand, if the government is completely unresponsive to economic injustice, political instability may thoroughly disrupt economic growth. It is not surprising that the early stages of industrialization are accompanied by political turmoil. In other words, because of the prevailing conditions of scarcity, the government cannot afford to provide extensive public education; nor can it provide unemployment compensation or other programs of economic assistance to the less-well-off. Furthermore, since its tax revenues are small, the government cannot use taxing policies to redistribute wealth or indirectly subsidize favored economic activities. And certainly, the government is unable to carry out a national industrial policy.

Therefore, a private enterprise economy with minimal government involvement is best-suited to furthering economic growth in the era of generalized scarcity. In the early phases of industrialization, particularly during the drive to maturity, productivity and wealth increase rapidly, but the maldistribution of wealth is extreme. There are, typically, the super-rich unrestrained by government regulation, a small but growing middle class and a poverty stricken majority. This situation may be deplorable from an ethical point of view, but it has some advantages from a macroeconomic viewpoint in that the wealthy elite generate the capital needed to stimulate continued economic growth. On the other hand, more effective practices and institutions, such as banking and insurance which pool resources and risk, can tap the savings of large number of people of modest means.

The twentieth century has provided the occasion for social experiments involving government control of the economy, including ownership of the means of production (socialism), during the stage of the drive to maturity. In some ways the relatively primitive (meaning simple) state of the economy in that stage lends itself to government control. The task of regulating the various mechanisms of the economy: prices, wages, allocation of resources and production, is not as complex as it would become in a later stage of industrialization. However, the degree of government control that is necessary to accomplish this evokes liberal opposition and requires a powerful government to repress dissent and maintain control. The extreme example of this in the twentieth century is Stalinist Russia. With the general collapse of socialist governments toward the end of the century, it appears that the results of the experiment are in. Centralized planning and control of the economy cannot cope with the increasingly complex myriad of economic decisions which must be made daily in the later stages of industrialization. This can be done best by millions of private entrepreneurs and consumers, accustomed to having the freedom to make their own economic decisions in the framework of the marketplace.

Having said that, it is now important to focus upon the continued evolution of capitalism in the ongoing industrial revolution. A laissez faire economy, left indefinitely to its own course, will subject society to severe tensions. While the late 19th century western European experience demonstrated that wealth generated in the drive to maturity did filter down to some extent to the less-well-to-do majority, it also showed that the more-well-to-do minority continued to dominate the economy and the politics, and continued to expand its privileges in the face of continued deprivation and exploitation of less-privileged groups. If this sounds contradictory, it is not surprising. What it does, in fact, is to reflect the complexity of mass society in the twentieth century. Furthermore, the drive to maturity begins to give way to the age of mass consumption. When that happens, most of the rules that prevailed in the era of scarcity change dramatically. In other words, the age of mass consumption heralds a new era in which there is a prevailing generalized condition of surplus.

In an age of surplus, the first priority in maintaining economic growth is no longer production or the supply side of the equation. Instead, the priority is to maintain consumption or the demand side. Given the developed productive capacity of industry, it can readily increase production to meet demand, but, if demand is not there, industrial leaders will have no motivation to expand plant facilities or increase production because they will be unable to sell their products. The demand created by a well-to-do minority is insufficient. A large middle class and a large working class, who are sufficiently well-off, are needed to maintain demand. It, therefore, becomes important, for macro-economic reasons, that there be a degree of equity in the distribution of wealth to enable the middle and working classes to save and to possess buying power.

If circumstances are left entirely to the marketplace, over the long term, the corporations and the wealthy who have more control and more financial options available to them, will become wealthier, and a maldistribution of wealth will occur. This will eventually exhaust savings in the hands of most consumers and lead to a decrease in consumption. In order to prevent this, it is essential that the society invest in mass education which will raise the skills and earning power of the middle and working classes; in social security programs which provide senior citizens with the ability to maintain their demand for goods; in unemployment programs and welfare assistance which maintain consumption by the unemployed and the poor; and in the maintenance of a transportation and service infrastructure which facilitates the activities of profit-making production and consumption in both the public and private sectors. It cannot be expected that the private sector alone, can ask the "right" questions, carry out the necessary research (which is often very costly and does not generate a profit), or possess the broad perspective needed to plan programs which will be essential to the well-being of the general public.

Fortunately, in the age of mass consumption, the private sector generates sufficient wealth ,which can be tapped through taxation, to provide the government with the resources needed to accomplish the above-mentioned goals. Furthermore, as the size of the government's role in the economy expands, the options that are available to regulate the economy also expand. A progressive taxation can be an effective means of preventing a maldistribution of wealth. Government regulation of labor-management disputes can assure a level playing field between the two sides, and government regulation of financial markets can limit corruption and provide a secure environment for public investment. On the other hand, the government can become so large and draw so much of the surplus that it can begin to drain the capital needed by the private sector for productive investment in profit-making activities, and it can withdraw resources (through taxation) which diminish consumer demand. Therefore, while it is easy to explain what needs to be done in theory, it is difficult to find the optimum point in practice. Furthermore, government can also become a source of misallocation of resources, waste, and corruption, and it can also be exploited for private gain to the detriment of the public interest. These have been hard realities which have not yet been resolved in the twentieth century.

In spite of the inherent problems associated with the government, it is the only institution in society which can accomplish the aforementioned goals. The private sector is fragmented into a variety of special interests. Corporations and individuals are motivated to pursue their own specific goals which are not always compatible with the general welfare.

The state of the economy in relation to the business cycle is important in trying to assess what measure of government intervention in the economy is needed. The government can act effectively to stimulate the economy during a depression by decreasing taxes or increasing government expenditures, and theoretically, it should be able to combat inflation by increasing taxes or decreasing government expenditures. This would be learned through historical experience in the twentieth century.

Before the Great Depression, which began in 1929 and lasted for a decade, the accepted consensus among political leaders was that the government could do little if anything about the business cycle. The Depression began in the United States and spread to Europe because the European economy had become dependent upon the U.S. economy after World War I. The Versailles Treaty, which established the terms for ending the war, placed a reparations burden upon war-torn Germany. At the same time, the United States insisted that loans incurred by the western Allies to the United States to pay for the war effort must be paid back. England and France were unable to pay their debts to the United States without receiving German reparations. Meanwhile, the United States refused to recognize any connection between reparations and inter-Allied debts. The U.S. had not demanded any reparations from Germany. This system was unrealistic in that it set up a flow of capital which began in the devastated economy of Germany and ended in the strongest economy in the world, that of the United States. The system collapsed when the Germans defaulted on their reparations in 1923. The French, attempting to compel the Germans to pay, occupied the Ruhr industrial region, and the Germans responded with a refusal to work. The resulting paralysis of the German economy led to hyperinflation.

Reforms introduced in 1924 had to include a continuous influx of capital from the United States, the only national economy strong enough to do so. This was accomplished through the sale of German bonds to U.S. private investors. Thus the system was restored and continued to function until the Depression struck the United States economy. When the stock market collapsed, billions of dollars of paper values disappeared and U.S. investors could no longer buy German bonds.

Why had the strongest economy in the world slipped into depression in 1929? A simple explanation can be made by stating the obvious; that business cycles will come and go and the prosperity of the decade of the Twenties had to be followed by a down-turn. The usual band-wagon psychology of a boom persuades people to invest even after employment levels and corporate profits have levelled off. When the differential between stock prices and corporate earnings continues to increase, selling pressure finally develops and then snowballs as the optimistic boom psychology is replaced by a pessimistic bust psychology. The fact that the stock market was the single largest investment sector in the 1920's, rendered the economy more vulnerable than would otherwise have been the case. And a number of financial practices made it too easy for American citizens to invest, thus encouraging millions to invest when their individual situations were precarious. Buying stocks on 90% margin is one example.

The United States' economy was in the age of surplus by the 1920's. This condition compounded the difficulties involved in recovering from the Depression. Since consumer demand had become the primary element needed to sustain a healthy economy, and the downward phase of the business cycle progressively reduced employment and eroded consumer confidence, the private sector continued to cut back its production. This self reenforcing cycle deepened the depression. Only the government could respond, but government failed to do so because of the prevailing hands-off philosophy. Hence, this depression was deeper and more long-lasting than ever before.

The political system responded to the problem through the election of a new President in 1932. Roosevelt, who had campaigned on the promise to balance the budget in order to set an example of fiscal prudence, did not understand how to deal with the problem any more than did former President Hoover. The essential difference between the two men was that Roosevelt conveyed an optimism and a determination to take action which helped to restore hope that something could be done. The closing of the banks and subsequent re-opening of those considered by the Federal government to be solvent, restored confidence in the banks. When people were on the verge of starvation and no one could help them, Roosevelt provided emergency grants through the Federal Emergency Relief Act. This was followed by public works programs which, while initially hastily organized and inefficient, gave millions of the unemployed some income. A proliferation of such programs could only be financed by creating a Federal deficit. In other words the Federal government began to provide the consumer buying power which the private sector was unable to generate.

Roosevelt's program, referred to as the New Deal, was put into effect, not as a result of a theoretical understanding of how to cope with the problem, but as a practical response to human needs. The English economist, Lord Keynes, had by then, developed his theory that the government can deal with a depression by running a deficit and "priming the pump." It was, however, a theory not yet accepted by political leaders. Roosevelt's lack of acceptance of the theory caused him to take the correct steps only reluctantly and insufficiently. As a result, the depression, although relieved to some degree, continued to persist throughout the decade of the Thirties. In fact, when Roosevelt began to cut back on some of the programs after his re-election in 1936, the economy began to slip further into depression. Slow recovery was resumed by renewing government programs, but the final recovery did not come until World War II, when the unlimited needs of the war effort led to an unprecedentedly high level of government expenditure without regard for the size of the deficit.

The demands of World War II stimulated a tremendous growth in the U.S. economy, and a great increase in the role of the Federal government. Furthermore, legislation passed into law under the New Deal provided permanent and automatic processes which would help to maintain consumer demand whenever economic decline occurred. Social Security, unemployment compensation and a welfare program for the indigent poor all accomplished that purpose to some degree. The Wagner Act (National Labor Relations Act) helped labor unions to organize and to protect the workers' share of the growth in national income by guaranteeing the right of Labor to bargain collectively with Business. A progressive income tax helped considerably to maintain equity in the distribution of wealth.

World War II, followed within a few years by the Cold War, motivated the development of a more-or-less permanent large military establishment in the United States. The production of weapons and the assumed need to maintain a large military establishment required that the government issue extensive contracts to private businesses on a continuous basis. This, added to a continuing expansion of government involvement in providing for social and other societal needs, meant that government became a permanent, large factor in the economy.

Business, stimulated by consumer demand postponed by the war, and by the flow of governrnent contracts, also continued to expand from the very high levels of production achieved during the war. And Labor, protected now by government, also grew large and economically powerful. Thus the U.S. economy was fundamentally different from what it had been before the war.

Big business, big labor, and big government were essentially economic monopolies which could persist in carrying out activities in defiance of the normal pressures of the market place. They each acted in such a way as to create a permanent high level of demand and a permanent inflationary pressure upon the economy. Business and Labor bargained respectively for higher prices and higher wages, and government maintained a high level of expenditures. Government mortgage insurance and the legalization of 30-year home mortgages stimulated a substantial growth in the housing industry. The housing sector was to become the largest single sector in the economy, and the public sector second largest. The stock market, though still significant, was not as large a factor. The circumstances which led to the Great Depression could not re-occur.

The United States emerged from World War II with a commanding economic advantage over other parts of the world. With the European economy devastated by the war, the United States was producing more than 60% of total world production at the end of the war. Some of the worst mistakes made at the end of World War I were not repeated. In 1947, the United States initiated the European Recovery Program (the Marshall Plan) which granted about $13 billion worth of goods to war torn-areas of western and southern Europe. The European economy experienced a more rapid economic recovery and more political stability than had occurred after World War I, even though the devastation of war had been more complete after World War II. Western European nations became healthy trading partners of the United States, stimulating a period of unprecedented prosperity in the Atlantic economy during the Fifties and Sixties.

In order to avoid some of the problems encountered after World War I, and to establish a healthy world economy after World War II, economics ministers of the United States and their major European Allies met at Bretton Woods, New Hampshire in 1944. There they agreed to establish gold plus dollars as an international currency with the United States guaranteeing an exchange rate of 1 oz. of gold equal to $35. The dominant position of the U.S. economy made this possible. It created a stable currency whose supply could be expanded to correspond to an expanding volume of world trade. As long as the U.S. economy retained a dominant position in the world economy, this agreement could be maintained. It was maintained until 1971, thus enabling the Atlantic World to enjoy extraordinary growth and prosperity for 27 years. The conference also created the International Monetary Fund which was organized to provide economic assistance to national economies that were in trouble, giving them time to address the internal weaknesses of their economies.

As the European and Japanese economies recovered from the war they became increasingly competitive with the United States economy. The United States shouldered a heavy armaments burden because of the Cold War. Therefore, priority was given to investment, research, training and employment of skilled engineers and scientists in the defense industry. Consequently, the United States gradually lost its competitive advantage in consumer goods production. Furthermore, the expenses of maintaining a vast Cold War network of military bases were a negative factor for the U.S. in its balance of payments with other nations. In spite of these factors, the U.S. retained a positive balance of payments throughout the
Fifties. In the Sixties, however, the U.S. balance of payments became negative. European nations rapidly accumulated huge sums of dollars collected to balance the international ledger. It became evident that the United States could no longer honor its pledge, made in 1944, to exchange gold for dollars at the agreed exchange rate. The situation was exacerbated in 1970, when the U.S. for the first time in its history, became a net importer of oil. This caused the balance of payments to swing more sharply negative. In 1971, the Nixon Administration announced that the U.S. would no longer exchange gold for dollars at the agreed rate, and the Bretton Woods agreement expired.

Meanwhile, the U.S. domestic economy experienced some rude shocks during the Sixties. The Kennedy Administration, elected in 1960, had followed now-recognized Keynesian techniques to stimulate a sluggish economy by reducing taxes. This stimulated the private sector while increases in military spending were increasing the public sector growth. The result was, as intended, an increase in economic growth. By 1965, however, the Johnson Administration had become heavily involved in the Vietnam War. The additional increase in public sector expenditures, not compensated for by a timely and sufficient increase in taxes, began to create inflationary pressures. In an economy with permanent monopolies, an inflationary spiral became very difficult to control. As prices increased, Big Labor demanded an increase in wages. As wages increased, Big Business increased prices further and a push-pull inflation began. Big Government, committed to a host of programs each of which had their particular constituency, found it difficult for political reasons to reduce expenditures. The other alternative, raising taxes, was also difficult because it was unpopular with the public. Keynesian techniques were effective in combating a recession since the appropriate fiscal measures, lowering taxes and/or increasing governrnent expenditures, were politically popular. But the appropriate fiscal measures to combat inflation were politically unpopular. Therefore, the United States entered into a period of high inflation which endured until 1982.

The sharp increases in the world price of oil during the Seventies further exacerbated the U.S. inflation. Since a higher price for oil translated into higher prices for almost every product in an industrial society, the impact was severe. Since fiscal policy was not effective for political reasons, the only way to combat the inflation was through monetary policy. The Federal Reserve Board was somewhat insulated from political pressures because it was an independent agency whose members were appointed rather than elected. By raising interest rates and otherwise increasing the cost of money, the Federal Reserve could restrain inflation. But the policy was not without its drawbacks. Some sectors of the economy, particularly the housing sector, were immediately affected because they were dependent on bank loans. But other sectors, dominated by the three major monopolies of economic power; business, labor and government, could resist the monetary restraints for some time.

Consequently, monetary policy created a recession in some industries while inflation continued in others. The existence of recession and inflation simultaneously created a dilemma for which was there was no Keynesian answer since the remedies for one problem only exacerbated the other problem.

The inflation was finally broken in 1982 by a combination of factors. First, the Federal Reserve Board had been carrying out a determined and persistent policy to restrain the growth of the money supply and make money more costly in spite of the severe restraints on growth which that policy created. Secondly, the price of oil dropped sharply and relieved the enormous inflationary pressures which had developed.

The inflationary cycle was broken in spite of an inflationary fiscal policy carried out by the Reagan Administration. A reduction in taxes, coupled with an increase in government expenditures would have added to the inflationary problem had not the inflation been broken before most of that fiscal stimulation began to have an impact. Instead the economy moved into a period of prosperity favored by a continued low price of oil. However, the enormous gap between government revenues and expenditures created a deficit which threatened to paralyze the economy. The problems were not immediately apparent and the public, enjoying prosperity, was not generally concerned.

The tax cut had favored the wealthier segment of the U.S. economy. Most middle class Americans were also doing well, but the poor were becoming increasingly numerous and increasingly desperate. Problems of homelessness and crime and drugs were mounting. The increase in government expenditures was primarily in the defense industry and in entitlements such as social security, medicare and medicaid. The investment by the Federal government in a variety of public services had declined in an effort to reduce the size and cost of government. State and local governments, left to bear the burden of public services with diminished Federal assistance, were overwhelmed. The Federal deficit had been financed, in part, by extensive investment by foreigners. High interest rates had attracted foreign capital into the United States.

In the decade of the Nineties, all of these problems had become more obvious. The end of the Cold War brought the beginning of the end to the extraordinarily high military spending. But after forty years, the economy had become dependent upon that government stimulus even while it had become less competitive in consumer industries. Furthermore, the rate of expansion of the defense industry had only recently increased during the Reagan Administration. The continuation of corporate profits and millions of jobs depended upon continuing weapons production even though the weapons were no longer of any use. The needs of millions of Americans, particularly the poor and ethnic minorities, had been neglected during the Eighties. The public infrastructure necessary to an industrial society had been disintegrating for lack of maintenance and replacement throughout the Seventies and Eighties. Educational opportunities, which had been expanding through the Fifties and Sixties, levelled off in the Seventies and began to decline in the Eighties.

While there was an urgent need to re-adjust to a peacetime economy and to apply cutbacks in military expenditures to other urgent needs, a persistent recession made it difficult to develop alternative sources of profits, incomes and jobs. Under pre-Cold War circumstances, Federal fiscal policy: reducing taxes and increasing Federal expenditures, would have been the appropriate response to bring about a rapid recovery. But, after forty years of deficit spending for the Cold War, the Federal deficit (about $6 trillion) had become so large that the financing of the Federal debt had become the third largest single factor in the annual budget. It amounted in 1992 to about $200 billion, exceeded only by social security payments and by the military budget. The application of the fiscal policy needed to combat the recession would increase the deficit further.

Meanwhile, the world economy had had to adjust to the wide fluctuations in oil prices, rising rapidly in the seventies and declining temporarily in the eighties. The industrialized world had adjusted through the gradual inflation in the prices of manufactured goods, but less-industrialized areas without oil survived only by going heavily into debt. International banks, which received investments from oil-rich countries and from the industrialized countries, extended loans to the poor nations. Debt payments created an annual outflow of capital from poor countries to rich countries ,as payments exceeded economic aid from the rich countries. The flow of funds was not unlike the flow from Germany to the Allies to the United States after World War I, a flow from the poor to the rich.

After the collapse of the Bretton Woods agreement in 1971, the industrialized countries created a floating system of exchange rates between gold, dollars and other major currencies. The exchange rate varied daily according to supply and demand thus immediately reflecting the perceived relative performances of the national economies which supported those currencies. This system more accurately responded to the reality that the United States' economy was no longer dominant in the world, but that it was one, though still the largest, among others. It also meant that the United States was more dependent upon the international economy and that solutions to economic problems depended more than ever upon cooperation with other nations. Whatever one nation did with respect to its national economy quickly had an effect upon the rest of the world. This further complicated the policies needed to grapple with national economic problems.

In conclusion, the age of surplus had raised possibilities that age-old problems of economic deprivation might be solved. But the inability to maintain an equitable distribution of wealth reduced demand and led to depression. Keynesian economic policy proposed a promising solution involving government deficits and an enlarged role of government in the economy. Instead the solution came through the medium of government deficits to pay for war. War and armaments and the habit of incurring large public and private debts became so costly as to inhibit the application of Keynesian techniques. Meanwhile, national economies became so inter-dependent that economic solutions had to be global solutions. In addition, a multiplying population growth, particularly in the less developed areas of the world, posed a host of new economic problems. Furthermore, the economic activities of humankind had become so intensive and intrusive that they threatened the global environment. As the twentieth century came to an end, it appeared that an age of surplus was no longer an accurate name for our times, but that very different conditions now apply.

HS-22 Readings